Sourcing Deal Flow

“Not all those who wander are lost.”

J.R.R. Tolkien in The Fellowship of the Ring

Deal flow in venture capital is basically the business ideas or projects that entrepreneurs or startups looking for money present to a venture capitalist or a VC firm. The more projects a VC firm gets to look at, the better chance they have of finding a great business to invest in. This continuous flux of ideas is the lifeblood of the venture capital world, and its significance cannot be overstated.

We all invest in something: Investors put their money into promising ventures, while entrepreneurs pour their time and energy into cultivating their ideas and bringing them to life. Regardless of what’s being invested, one thing holds true: the need to source and choose wisely.

The careful selection of what to invest in is crucial for both parties. Investors aim to allocate their capital efficiently, seeking out the most promising projects that offer the highest potential return. Similarly, entrepreneurs seek to invest their time and talent where they can make the most significant impact. Therefore, sourcing high-quality projects isn’t just a routine task — it’s a strategic move for both investors and entrepreneurs. In the following sections, we’ll delve deeper into the ways to source and manage deal flow in the complex world of biotech and science.

The Investment Landscape

Venture capitalists, across the board, use a variety of strategies in sourcing deal flow, ranging from a passive, wait-and-see approach to an active, opportunity-seeking stance. Many VCs operate by reviewing the proposals they receive and selecting the best ones from this pool. Other VCs, actively venture out into the field to discover promising opportunities in addition to fielding incoming proposals.

One crucial element in the selection process is the alignment of potential projects with the strategic roadmap of the fund. For a venture to fit into our portfolio, for example, it must resonate with our vision of the future of medicine. In our case, the strategic roadmap around the forest and the trees, serves as our guiding principle, helping us evaluate whether a prospective venture aligns with our investment philosophy, focus areas, and risk tolerance.

To illustrate the various strategies of sourcing deal flow, we may draw parallels to fishing methods. The first scenario, where VCs passively receive proposals, is akin to casting a wide net. This approach captures a large volume of opportunities, yet lacks precision. The second scenario, where VCs actively scout for prospects, resembles hunting with a harpoon. Here, the focus is less on volume and more on the precise targeting of opportunities that align with the VC’s strategic roadmap. As we move forward in this article, we will further explore these “fishing” methods and how they apply to the biotech investment landscape.

The Role of Strategic Alignment in Deal Sourcing

A strategic roadmap in the investment landscape is more than a plan; it is an informed, dynamic, crucial guide that outlines the path to potential investment opportunities. This roadmap lays out an investor’s vision of where they see the future of biotech and medicine heading and which fields or technologies are likely to play a significant role in shaping that future. It represents a well-reasoned hypothesis of which sectors, technologies, or types of companies might produce the most impactful returns in the coming years.

A well-crafted strategic roadmap can serve multiple functions. It guides the investor in navigating the complex world of biotech, helping focus their attention on areas of most significant potential and saving time by narrowing down the scope of search. Furthermore, the roadmap helps align the portfolio with future trends, keeping the investments relevant in a rapidly evolving industry.

For venture capitalists, the strategic roadmap becomes an essential tool for sourcing deals. With a clear roadmap, investors can move beyond a reactive stance, where they merely respond to opportunities as they come. Instead, they can actively seek deals that align with their vision, their understanding of the market, and their anticipation of future trends. This alignment of deal sourcing with strategic roadmap not only increases the odds of successful investment but also helps build a cohesive portfolio that makes sense in the context of broader industry evolution.

Finding deals that perfectly align with a strategic roadmap is a task easier said than done. The inherent uncertainty of the biotech industry, marked by disruptive breakthroughs and swift changes in market dynamics, often challenges the foresight encapsulated in the roadmap. The truth is, I constantly change my mind, evolving with where science goes. Every quarter I realign my own expectations with the current status of the field and re-draw my maps of what interests me. This iterative process allows investors to stay attuned to the pulse of the industry, making them better equipped to source and manage deal flow wisely.

Deal Flow Sources

1. Incoming projects from entrepreneurs sending their decks

VCs often receive a plethora of proposals from entrepreneurs seeking investment. These inbound projects, akin to a fisherman’s net, catch a variety of opportunities, some of which may have great potential. However, the sheer volume of these inbound projects presents its own challenge: finding the one that fits perfectly with the VC’s strategic roadmap. It requires sifting through a multitude of proposals to spot the rare gem that aligns with the investor’s vision and market prediction. Despite these challenges, inbound projects remain a source of deal flow, as they sometimes bring unexpected opportunities to light.

Entrepreneurs view this method as an opportunity to showcase their innovative ideas and gain the attention of potential investors. However, they may find it challenging to stand out amid the multitude of proposals received by venture capitalists. Tips for entrepreneurs include crafting a clear, compelling, and concise pitch deck that highlights the uniqueness of their project and aligns with the potential investor’s strategic interests.

Venture capitalists may appreciate the diversity of opportunities this method presents but may be overwhelmed by the high volume of proposals. Their challenge lies in efficiently sifting through the decks to identify promising projects. While this method can lead to discovering unique opportunities, it also carries the risk of cognitive biases like the “halo effect” where an entrepreneur’s presentation skills might overshadow the project’s actual merit. I advise maintaining a disciplined evaluation process to mitigate such risks.

2. Referrals from other funds

Investing in biotech is not a solitary pursuit; it thrives on collaboration, shared insights, and collective wisdom. This principle underpins the strategy of sourcing deals from other venture capital firms. In this context, the importance of maintaining a strong network within the VC community cannot be overstated. Being trustworthy, humble, and committed with a strong track record of identifying winning investments and actively supporting portfolio companies can open doors to collaboration and co-investment opportunities. Upholding high ethical standards further enhances the VC’s reputation, facilitating the flow of deals from peers in the industry.

Referring VCs utilize this method to diversify risk, gain access to additional resources, and benefit from shared due diligence and industry insights. However, they must carefully select who they invite to ensure compatibility in investment strategy and a commitment to shared goals. To maximize this strategy, referring VCs should maintain a well-curated network of reliable partners who bring complementary skills and resources. For the VC receiving referrals, this approach presents opportunities to gain access to curated deals, reducing the time and resources required for deal sourcing. Nevertheless, they must critically assess each opportunity to avoid potential groupthink and maintain alignment with their strategic roadmap. A healthy mix of trust in the referring VC’s judgment and independent validation of the deal’s merit is essential.

Sourcing deals through referrals brings together diverse perspectives and resources, enhances deal access, and fosters collaborative innovation. To be effective, it requires a robust due diligence process, clear communication, and well-defined co- investment agreements. This collaborative approach underscores the interconnectedness of the VC ecosystem and the power of collective wisdom in driving biotech innovation.

3. Sourcing projects based on a map of strategically interesting fields

Like a hunter wielding a harpoon, a VC can actively seek out investment opportunities based on a well-charted map of the biotech ecosystem. This approach is proactive and highly targeted. It relies on a clear understanding of the state-of-the-art and emerging technologies, with a strategic selection of the areas that will shape the future of medicine. This method often involves creating a shortlist of the best companies in a chosen field and then deep-diving into these options to select the most promising one for investment.

The process of selecting the best companies in a particular field is a meticulous task. It involves extensive research, rigorous due diligence, and a keen understanding of the field’s dynamics. Once the top contenders are identified, the selection process narrows down further. The final choice of investment is not a decision taken lightly; it reflects the VC’s conviction in the company’s potential and its fit with the strategic roadmap.

This proactive method enables VCs to align their investments with their strategic focus and vision for future trends in biotech. However, it requires extensive knowledge and foresight, and the success of such a strategy greatly depends on the accuracy of the VC’s predictions about future trends. To be effective, VCs must stay abreast of developments in their focus areas, maintain flexible strategies to accommodate emerging trends, and be willing to invest the necessary time and resources into comprehensive due diligence.

Entrepreneurs might appreciate the targeted interest from VCs employing this strategy, as it implies a deeper understanding and commitment to their specific field. On the other hand, they may feel under greater scrutiny given the meticulous selection process. This proactive method is a more focused and calculated investment strategy, one that could yield higher returns given the careful selection process. Continuous learning, comprehensive due diligence, portfolio diversification, and collaboration with other VCs can enhance the effectiveness of this strategy.

4. Academic publication-driven sourcing

Scientific journals such as Nature or Science serve as fertile grounds for sourcing potential investments. These publications cover cutting-edge research and innovative solutions, offering keen-eyed investors an early glimpse into the next big thing in biotech.

Spotting potential investments through these publications isn’t just about early-stage investing; it often involves company creation. This route requires engaging with scientists to build a company around their groundbreaking research, offering a unique opportunity to shape the company’s journey right from its inception. This method can provide early access to groundbreaking research and innovative ideas, offering potential high returns. However, it’s labor-intensive, requiring an understanding of advanced scientific concepts and the ability to communicate with researchers effectively. For success, VCs should maintain close ties with the academic community, and keep up to date with the latest research publications.

Scientists may appreciate the interest and validation from the investment community and the opportunity to bring their research to the market. However, they might also be wary of the potential commercial pressures that could compromise scientific integrity. They should ensure that they partner with VCs who respect the balance between commercial success and scientific rigor and who can communicate effectively with them about their work.

Academic publication-driven sourcing is a highly specialized strategy that requires significant scientific understanding and a close relationship with the academic community. We cannot hide that this source might be perceived by everyone as high-risk, given the uncertainty associated with translating early-stage research into a commercially successful product. However, it can be also seen as high-reward, given the potential for breakthrough innovations. If you know how to do it well, it is, in my opinion, a great way of building your portfolio.

One of the first challenges in company creation is assembling a competent team. This includes hiring a CEO, a decision that’s far from easy. In these early stages, the kind of seasoned CEO that a VC would ideally want on board often won’t be interested. It’s simply too early, and the company isn’t yet stable or well-funded enough to attract top talent.

This is where the concept of an interim CEO comes into play. An interim CEO is a trusted individual from the VC firm, often an “Entrepreneur in Residence,” who steps in to manage the company until it matures and can attract a long-term CEO. They can navigate the company through these delicate early stages, ensuring it gets off to a solid start.

Another key challenge lies in building a syndicate of investors. Your reputation as a VC plays a critical role here — it can make or break potential investment opportunities. Occasionally, a VC firm might decide to invest alone. While this can seem risky, the potential rewards are high if the company is properly structured and can hit key scientific milestones. If everything aligns, the company’s upvalue at the next funding round could be significantly high.

Starting with a small board of directors is generally the best approach. As the company matures, you can bring in independent board members who offer diverse perspectives and expertise. A chairperson, who can provide effective leadership and direction for the company, is also essential. All of these elements need to be implemented step by step to professionalize the company gradually.

The process is by no means easy. The sheer number of decisions to be made can be overwhelming, and each one carries weight. However, the rewards are immense. Each company created by a VC contributes something new to the future: a ground-breaking technology, a life-saving therapy, a revolutionary product. Every successful company represents a step forward, and as a venture capitalist, you get to be a part of that progress. You’ve taken an idea, a mere possibility, and turned it into a reality — a company that wouldn’t exist if not for your vision and efforts. It’s a challenging yet fulfilling journey that contributes to the betterment of our future.

Excerpted from Fast Forward Thinking: 40 Rules for Entrepreneurs and Investors in Medical, Science, and Biotech by Luis Pareras, MD, PhD.